In financial terms, the derivative contract derives its value from the performance of an underlying property. This property – asset, index, or interest rate – is called the "underlying". Derivatives are one of three primary financial instruments, the others being debt and stocks.
One of the more common derivatives is an option, which provides the buyer (owner) the right, but not the obligation, to buy or sell an underlying instrument at a specified strike price on or before a specific date. If the buyer exercises the option, the seller has the obligation to fulfil the agreement. To receive this right in a public market, the buyer pays a premium for this "call option". The owner's right to sell at a certain price is termed a "put option".
For privately-held securities, options are granted at prices "out of the money" or "at the money". Otherwise, if the option grant were "in the money," meaning the call option price was less than the current per share value, the owner of the option would pay an income tax on the value immediately received (market value less option price).
In addition to the use of the Black-Scholes model, especially for public securities, our financial valuation professionals use binominal models. These latter processes include numerous iterations of the following:
- Intrinsic value, or the difference in market value between the underlying and the strike price.
- Time value, which reflects the discounted expected value of the above difference at expiration.
In order to simultaneously consider the multivariables, we utilize a Monte Carlo simulation. This program produces 10,000 iterations for each changed assumption, which significantly narrows the band of intrinsic and time values.
The primary uses of derivative valuations are:
- Common stock for Internal Revenue Code Section 409A, for the option call price in computing the income statement compensation charge.
- Put options to quantify the lack of marketability discount.